Lu Han, Seung-Hyun Hong
Review of Finance, Volume 28, Issue 6, November 2024, Pages 2083–2118, https://doi.org/10.1093/rof/rfae025
The recent decade has witnessed a steady increase in all-cash home purchases, which sky-rocketed to make up nearly one-third of all home purchases in 2021. In a competitive market without mortgage closing risk, a seller should take the highest offer she receives. In reality, stringent policies for income and assets documentation for mortgage approvals can delay or even entirely stall the transaction. Hence, an offer could win over other offers not only through the best price but also through the fewest financial contingencies. A cash offer is the cleanest offer that a seller could obtain, and thus, the price discount associated with a cash offer relative to a mortgage offer should reflect the degree of financing risk in the housing market.
Using Los Angeles housing transaction data, we find that the else equal, a cash purchase reduces time-to-close by about 29% and reduce the sales price by 2-3.9% discount compared to an else-equal mortgage offer. The discount is equivalent to almost half of the total compensation real estate intermediaries earn on a transaction, indicating substantial risk associated with mortgage closing. These estimates are robust to the inclusion of a rich set of fixed effects as well as an IV strategy. Benefiting from unusually rich data that contain information not only on housing transactions but also on listings, tax assessments and deed records, we are able to flexibly control for sorting between cash buyers and houses/listings/sellers, representing an improvement over the literature. Moreover, the estimates remain similar when extending the sample to cover the national markets (top 100 U.S. cities) and institutional buyers, thereby providing external validity.
The estimated cash discount aligns well with a canonical model calibrated to the sample market, suggesting that the model captures the underlying transaction process and supporting the proposed mechanisms through which financing risk is capitalized into the cash discount. In particular, closing risk alone is not sufficient to explain the cash discount. Rather, it turns on the possibility that a property back on the market may fail to sell, hence requiring a substantial premium to compensate the seller who accepts a mortgage offer. Moreover, the cash discount is smaller during booms, hot market months, and in larger markets, where the sell success rate for a relisted property is higher. This highlights the inseparability of financial frictions in the mortgage market and search frictions in the housing market.